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Stop press: What next as Europe winds down QE?

The European Central Bank (ECB) has reaffirmed its commitment to begin winding down quantitative easing (QE) operations by the end of the year.

This is despite what looks like choppy waters between now and the planned December end date. At a conference in Frankfurt on 25 October, ECB President Mario Draghi signalled that the bank wouldn’t be deterred by Italy’s looming confrontation with Brussels, Brexit risks or the current rout in capital markets.

The ECB’s governing council still “anticipates” an end to their asset purchases of €15bn (£13.1bn) a month, mostly in the form of eurozone government bonds. This is despite acknowledging the “weaker momentum” in the eurozone economy, and the threats posed to the global economy from Donald Trump’s trade policies, emerging market struggles and Brexit.

Unlike in the US, where the Federal Reserve’s monetary tightening came in response to the strength of the underlying economy, the ECB’s desire to turn off the QE liquidity tap isn’t motivated by booming growth. After a strong showing in 2017, data this year has been steady but uninspiring on the continent – not the usual background to a tightening of monetary policy.

But there’s not much that’s usual about QE. It formed a key part of the coordinated post-crisis monetary stimulus across the globe, keeping bond yields low and liquidity ample to spur growth in a financial system and economy that was devoid of confidence.

In recent years, the ECB’s QE programme in particular has been very successful, keeping interest rates well below growth rates. This ensures eurozone growth is fed back into the economy rather than ‘absorbed’ by savers, and eases the debt burden of eurozone nations.

So why are they so eager to bring it to an end? Like all the world’s central banks, the ECB has a strong desire to 'normalise' monetary policy. Despite the need for it, they are extremely aware that the last decade’s ultra-loose policy is a ‘desperate times’ measure more than a long-term solution.

Even aside from QE’s effects on wealth distribution and tendency to generate bubbles in certain asset classes, it’s an uncomfortable policy for central bankers.

One of an independent central bank’s foremost goals is to defend the value of its currency. But if markets suspect the bank will continue printing money over the long term and use it to fund government debt, confidence in currency will eventually plummet, particularly if fiscal policy expands.

The tension this can cause between governments and central banks (as monetary policy usually has to tighten when fiscal policy loosens) is one of the main reasons why central banks across the western world are nowadays independent – so that political agendas don’t interfere with their attempts to keep the ship stable.

This is exactly the tension we’re seeing in the US, where Donald Trump’s massive expansion of fiscal policy through tax cuts and defence spending is prompting the Fed to raise interest rates faster – to the dismay of Trump himself.

The case for being less 'stingy'

This tension also helps explain why eurozone interest rates are still the lowest they’ve ever been, and why the ECB’s asset purchases have continued for so long.

While European monetary policy is at historically loose levels, fiscal policy across the EU remains tight. A focus on ‘responsible’ (a eurocrat euphemism for ‘stingy’) government spending is endemic to the bloc; the uncoordinated nature of eurozone fiscal policy means Germany’s political obsession with budgetary prudence rules the roost.

This compresses growth potential across the bloc, which in turn forces the ECB to reluctantly keep monetary policy loose.

Even the bank’s QE programme comes with a clause to address German fears that ECB asset purchases would leave their taxpayers on the hook for other nations’ profligate spending.

The capital key – the ECB’s answer to these worries – divvies up ECB bond purchases on the basis of the size of each nation’s underlying government fiscal stance, rather than the size of their bond market. This capital key (recalculated every five years) depends on keeping the budget to GDP ratio low.

The larger export nations, especially Germany, can operate relative fiscal austerity and still grow reasonably. In turn, the ECB’s policy rewards them further. This means more money is funnelled into faster growing economies (read Germany) instead of the struggling periphery nations.

Of course, that stinginess removes a source of demand for the smaller nations. And, if a nation becomes so squeezed they turn to fiscal expansion as a last resort, they may find they’re kicked out of the ECB’s bond-buying party.

We’ve seen this with Greece, we’ve seen it with Italy before and we’re seeing it with Italy again. With a recalculation of the capital key coming up just as €117bn worth of European sovereign bonds are set to mature and be reinvested, markets fear we could be approaching another serious headache in the Italy saga.

Thankfully, Draghi has suggested the reinvestment of matured bonds will be done according to the previous weightings, rather than the updated capital key calculations. This should be a welcome development for the Italian government, providing some help in avoiding a refinancing nightmare.

It probably won’t go down as well in Germany. But until they themselves start loosening fiscal policy, changes to the capital key rule are the least they can expect. Many would agree an end to the over-stinginess, probably through a European fiscal expansion, is a key part of getting the eurozone growing again.

But this expansion can’t come from the already troubled pockets in Greece, Italy or Portugal. Just as the bloc needs a normalisation of monetary policy away from ultra-loose, it needs an equal normalisation of fiscal policy in the core countries away from 'tight'.

Angela Merkel is probably as weak as she’s ever been during her time in power. Though it won’t win the approval of all Germans perhaps more government largesse could be popular, when seen as a consequence of a strong domestic economy and record budget surpluses.